Diversification is a cop-out :: Author: Alan Kohler Date: 07/08/2006 Publication: Eureka Report
PORTFOLIO POINT: Instead of trying to minimise risk by diversifying, Roger Montgomery prefers to do it by understanding companies he invests in, and their prospects. As the stockmarket enters a period of slower growth and heightened volatility, investors in managed funds will now be looking for “stock pickers”. Roger Montgomery is the managing director of Clime Capital, a $36 million listed investment company (LIC) that has made its name on an ability to pick undervalued stocks.

Although Clime Capital only held 10 stocks in the 12 months to June 30, two of them — The Reject Shop and Credit Corp — were exceptionally successful, doubling in price over the year.

Montgomery is a high-conviction investor and a great believer in the principles of Warren Buffett. Ironically, his fund has also become a target for the notorious sharemarket operator David Tweed who holds about 17% of Clime Capital and has made a bid for the entire company. Montgomery does not expect any of his shareholders to seriously entertain the offer from Tweed’s Australian Share Purchasing Corporation.

After enjoying a 28.7% return at Clime Capital last year — and even better returns among individually managed accounts — Montgomery is more convinced than ever that widely diversified funds do not benefit investors.

He does not hold any resource stocks and keeps about a third of his funds in cash. How does he do it?

The interview

Alan Kohler: Tell us how you went in the year to June 30. Roger Montgomery: For the listed investment company Clime Capital, we returned 28.7% for the year to June 30 and we held no resource stocks at all. We never do. And we had an average of 32% in cash throughout the year. So how many stocks do you own in the investment portfolio? Not that many. We are focused investors. We had no more than 10 companies — 10

Well they must have been big wins for you.

Since we started purchasing shares in those two businesses they’ve both more than doubled.

So I suppose you’re a testament to focusing on a few stocks and having a big win, but I guess the costs or the price of that is perhaps a less diversified portfolio.

It’s a mistake to believe that you reduce you risk by spreading your investments across a broad range of things you know nothing about. John Maynard Keynes said that and Warren Buffett’s taken it, I guess, to the next level by saying that diversification works for the “know nothing” investor. If you don’t know what you’re doing, broad diversification makes sense.

Well putting so much money into those two main investments of yours meant that if they, or one or both of those went bad, you would have been in big trouble.

It’s true. We minimised the risk of that happening by knowing the business very well and knowing with a very high degree of confidence what that business is going to generate in terms of return on equity. Then what we do is we reduce our risk even further by thinking of businesses that have manageable debt levels and high margins run by great management.

Can you tell us about how you do that?

Yeah. Look most of the models that are out there that I’ve seen, particularly the ones that are used by brokers, they’re mathematically flawed so that the most popular model that I’ve seen is what’s called the two-stage model and that has an explicit period of, let’s say, five to 10 years followed by a period which is designed to measure infinity … and that is eternal value.

Now the idea behind this particular two-stage model is that you calculate the free cash flows for the first 10 years and you discount them back to today and then you calculate a terminal value by capitalising the 11th year earnings, that means dividing it by a small percentage — 4–5% —capitalising that and discounting that back. The problem with the model, and not many people seem to have seen this, is that you’re double-counting those cash flows. Because when you discount the explicit period cash flows you are implying that they’re received but by discounting the terminal value you’re implying that those explicit period cash flows are retained and compounded. It can’t be both.

Why is that?

Well, let’s say you’ve looked at your investment universe. You’ve found one company that generates a 20% return on its equity. On every dollar of equity. And you can buy into that company for $1, which is the dollar of equity. So it’s going to produce a return to you of 20%. Now management has a choice: it can keep the profits and continue to generate 20% on incremental capital, on the increase in capital, or it can pay all the dividends out, all the earnings out to you as a dividend. Now if it pays all the earnings out to you as a dividend what else can you do with that money? Well, you’ve scanned the investment universe and you can only get 10%.

But what if you’re able to invest your dividend at more than 10, or more than 20%?

Well then the metrics change and that’s where your required return is higher than 20%. The company that actually pays it all out as a dividend must be worth more than the one that retains it.

So does that mean that you tend to look for companies that don’t pay dividends or don’t pay much dividend. That’s what Warren Buffett always did.

No, look, he decided not to pay dividends himself because he believed he could compound the money better than anybody else and he was right. And so it made sense not to pay dividends. We’re not interested if a company pays dividends or not but we’re able to value a company appropriately irrespective of whether they do or don’t.

If you’ve got a company like Flight Centre or ABC Learning where their profits have been going up pretty much every year, their number of stores or the number of centres is growing every year, and yet the return on equity for the business has been dropping substantially. Flight Centre’s return on equity has dropped from, gosh — what is it? — about 64% to about 18% in the past eight years.

How did you pick the two stocks — The Reject Shop and Credit Corp — that have been so successful for you?

We use a piece of software called StockVal, which is our valuation model embedded in a piece of software that scans the entire market on a daily basis for businesses that are trading below our estimate of their intrinsic value.

So the Reject Shop and Credit Corp both popped up on our scan one morning, and once a company does that we pay a lot closer attention to it and start to focus on the management of the business and what the company actually does.

What we liked about The Reject Shop was its $50 million market capitalisation yet it had 90% brand awareness among adult Australians.

The other thing that we liked about the business was that Barry Saunders was running it. Now Barry Saunders is the former chief executive of Big W and Target and also a former board member at both Woolworths and Coles Myer, so he’s used to running multi-billion dollar retail operations and here he was as the head of a $50 million retailer with 90% brand awareness.

The other thing that we liked about the business and what our StockVal software showed us was that the business had been generating over 40% return on equity to its owners every single year.

And on top of that, the shares were trading about $2.30–2.40 and we valued them over $4. It’s very rare, given the conservative nature of our valuation, so we immediately invested 10% of the funds, our portfolios, in that business.

I see, and what was the attraction of Credit Corp, which is a very different business?

Credit Corp is in the receivables management business, and previously the industry had included some colourful characters, but Credit Corp was positioning itself as a reputable operator being very conservative in the way it valued its ledgers.

We met with chief executive Jeff Lucas. He is very smart, very conservative and had a lot of integrity. We liked that.

And, again, we saw a business where the equity was increasing every year and the return on equity was going up every year and, again, we managed to come up with a conservative valuation that was significantly above the price.

Now what we liked particularly about that business is that it only buys personal loan and credit card bank ledgers so it’s not in the much more difficult collections space of car loans and/or mobile phones, so it focuses on better quality receivables.

What we know is that if they buy $100 owing to the bank and it’s 90 days in arrears, they buy that for a little bit less than $10. They put the consumer on a payment plan so they get that initial purchase price, that initial $10, back very quickly. The next $10 or the next three or four payments come in very quickly as well, obviously, and so they make a positive return reasonably quickly but what most people don’t seem to get is that the interest that’s owing on the $100 continues to accrue and they may in fact be able to collect that.

That is the reason I think the company has been able to exceed all the analysts’ forecasts year in year out and do better than everybody anticipates — because they collect the interest that’s accruing on the outstanding amounts. Not many people seem to understand that.

The message seems to be that if you get it right, in terms of doing your numbers properly and valuing the company correctly, you don’t need diversification.

I think broad diversification is a cop out.

Now, why don’t you hold any resource stocks?

Well look the reason we don’t own resource stocks is it’s not my area of … not my circle of competence. I don’t understand resource companies and I remember that Mark Twain once said: A gold mine is a hole in the ground with a liar on top.

They say we’re going to four white pegs in the ground, we don’t know how much stuff is really in the ground, we can’t be certain about that. We don’t know how much it’s going to cost to extract it.

Once we’ve got it, we don’t know who we’re going to sell it to and we don’t know how much we’re going to get for it. That’s supposedly a business proposal. I find that very hard to understand.

Any concerns about being exposed to the economy, the local economy, I guess, at a time when inflation seems to be rising and interest rates are going up?

Again we look at businesses that we think will survive and prosper irrespective of how the economy’s going.

So we’re not so concerned about the business cycle. It’s very much a bottom-up approach. We’re looking for businesses with bright prospects over the next five, 10 or 20 years, and we’re not so interested in the next interest rate rise, or the one after that.

So I guess the question that everyone’s going to want to know: what are your next picks?

There’s 14 companies here that appear to be reasonable value and, again … or I should say that just because they’re cheap doesn’t mean we go out and buy them. They may be in an industry we think doesn’t have bright prospects; they may be a business where we don’t like the management; they may be a business that don’t seem to be rational with capital allocation — so, for example, they may have a very high rate of return on equity but be paying all those earnings out as a dividend.

So what are the 14?

OK. Well at the top of the list is Funtastic, Corporate Express, Atlas Group, Woolworths, ANZ, Oamps, Macquarie Bank, Alumina, Fantastic Holdings, Home Leisure.

After that we’re getting down now to the companies that are trading right on their value: Nufarm, Sims Group, Repco Corporation and Just Group.

Not long ago we had brokers recommending Repco to us. We were being told to buy Repco basically all through from January 2005 through to August 2005 and the share price then was $3.50 and $3.00. Their valuation was significantly lower, in fact it was about $1.12 and the share price is now $1.12. We have no predictive ability at all.

Now if I can concentrate on ABC Learning for a second. It’s grown its profits from $6.9 million to $97.1 million in four years. Now that is a phenomenal result, there is doubt about that. That’s why the shares have gone from 40¢ to $8 but there is nothing remarkable about that earnings growth when I tell you that equity in the business has gone from $13 million to $1.8 billion. So over the past five years since it listed, the company has raised $1.6 billion from shareholders.

Now what is happening at ABC is what I call a rocking share principle. If you give me $100,000 and I go and invest it at 5% I give you a cheque at the end of the year for $5000. Do you think that’s a good return?

And that’s exactly what’s happened here with companies like Flight Centre and ABC Learning. Shareholders have just given the company more money. Yet those same shareholders only focus on the earnings growth rather than focusing on how profitable the business is with the money that they’ve given to the company to manage.

So this business, ABC Learning — its return on equity has dropped from 48% in 2002 to 8.8% forecast to 2006. So you’ve now got a business with $1.8 billion of capital generating just 8.8%. If you are requiring a 15% return on your money, and you’ve got $1 of equity in this business generating 8.8% you want 15% return on your money, the only sensible price to pay for the business is a discount to that $1 of equity. That’s the only way you’re going to get your 15%. So ABC Learning has $4.56 of equity per share and if we want a 13.5% return on our money, then the only sensible price to pay is $2.67. The shares are trading at about $6.20 or $6.30 or thereabouts; they were recently at $8.

Is that a sensible way to proceed in general? To look at how much equity is in each share and look at what price you need to pay to get it to generate a decent return on that?

That’s precisely what we do. Yeah. That’s exactly how we value a business.

So you look at the shareholders’ funds, divide it by the number of shares and then apply the profit to that?

We apply a formula to that equity to decide how profitable that equity is and what we’d be willing to pay given our required return. So ultimately we’re looking at a multiple of equity.

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